Weak Form

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The weak form of the efficient market hypothesis contends that successive
changes in stock price movements are independent of one
another. Consequently, no relationship exists between past and
future stock price movements. The weak form of the efficient
market hypothesis holds that historical information about stock
prices has no bearing on future stock prices. In other words, the
stock prices of today and tomorrow are unrelated to past stock
prices. Thus a comparison of two stocks, as illustrated in Figure
12–1, would be meaningless in predicting future price behavior.
Both stocks have a current price of $20 per share, but the stock of
Company X rose from a low of $2 per share to $20, whereas the
stock of Company Y fell from a high of $40 to $20. The weak form
of the efficient market hypothesis maintains that past stock prices
are independent of future stock prices. In other words, no relationship
exists between past and future stock prices. This hypothesis
would make futile the use of past prices, as shown in Figure 12–1,
to determine which stock to buy. Technical analysts would argue
that you would not want to buy a stock that has declined from $40
to $20 per share because of its downward trend. Technical analysts
would advocate buying Company X over Company Y because of
its upward trend going from $2 to $20 per share. In other words,
the weak form suggests that the use of charts and past prices in
technical analysis in the selection of stocks is inconsequential and
does not produce superior returns.

According to the weak form of market efficiency, stock prices
reflect all historical market data. The stock price already includes
the price history of the stock, the trading volume, and all other
information that forms the basis for technical analysis.

Figure 12-1
Evaluation of Past Stock Price Information in the Weak Form
of the Efficient Market Hypothesis

Studies testing the weak form of the efficient market hypothesis
show that stock prices appear to move independently or in a random
fashion because of the dissemination of information (Fama, 1965,
pp. 34–105). This statement refutes the view of technical analysts,
who assert that stocks move up or down in runs (trends). By spotting
the trend early, you can profit by sticking with the stock during its
uptrend or selling at the top of a downtrend.

For a number of years, the Wall Street Journal published results
that compared stocks picked by dart throwers with those chosen by
financial analysts. The stock picks of the analysts more often outperformed
those of the dart throwers. Does this experiment mean
that the weak form of the efficient market hypothesis has no validity?
No, argue academicians. According to Burton Malkiel and Gilbert
Metcalf, analysts picked stocks that were riskier than the market (40
percent more volatile) as opposed to the dart picks, which were only
6 percent more volatile. The second reason that the results are slated
toward the analysts is the favorable publicity from the competition,
which ran up the prices of the stocks picked by analysts (Dorfman,
1993, p. C1). If the advantages of the analysts had been taken away,
then the competition would have been on an even footing.

Technical analysts and many others on Wall Street dispute the
findings of the studies that support the weak form of the efficient
market hypothesis. After all, if the weak form is not valid, technical
analysts would be able to consistently earn superior returns by
charting and analyzing past stock price information to predict
future stock prices. The weak form, however, does not directly
refute the use of fundamental analysis in selecting stocks that may
produce superior returns.